For many generations of Kiwi investors, housing has been a one-way bet. But that may be about to change, says the Reserve Bank’s chief economist, Paul Conway.

Housing matters because everyone needs a place to live – it is fundamental to our wellbeing. It also matters because housing is by far the most common and most valuable investment for many New Zealanders.

On the flip side, rent and mortgage costs are also the biggest expenses for many households. Building houses is a big source of jobs in our economy, too – tens of thousands of people earn their livelihoods working in residential construction.

The housing market is also a key link between the real economy and the financial system in New Zealand, with home loans dominating the balance sheets of commercial banks. So, understanding how the New Zealand housing market works is really important for us at Te Pūtea Matua, the Reserve Bank of New Zealand. Recent changes to the remit for monetary policy – which tells us what we need to pay attention to in making interest rate decisions – also require us to assess the impact of our decisions on house prices.

One thing seems clear from the get-go: housing demand has tended to outstrip supply in New Zealand. As a result, housing has gone from being abundant and reasonably affordable to being scarce and prohibitively unaffordable for many, with house-price inflation here among the highest across OECD countries in recent years. Although this has generated strong returns for house owners, it has also increased the wealth gap between New Zealanders who own houses and those who do not. Kiwis who own houses – often older New Zealanders – have increased their wealth, while those who do not own houses have seen accommodation costs steadily increase, with many prospective younger first-home buyers struggling to buy a home of their own.

At the extreme, the number of families living in emergency housing such as motels has increased strongly and the OECD reports that we have one of the highest rates of homelessness across member countries. Even though the market has recently turned, with house prices down over the first half of 2022, house prices remain at very high levels in absolute terms and relative to incomes.

Shelter is a critical human right. So, having more people implies a need for more houses. But population growth is not the only driver of housing demand. For example, lower interest rates create extra buyer demand by allowing people to service a bigger mortgage with the same repayment. The way returns from housing are taxed also influences housing demand.

Housing stock has not kept up with population growth – the number of dwellings per person in our country fell from 2011 until the beginning of the Covid-19 pandemic. In contrast, dwellings per person increased in most other OECD countries over this period.

In part, this reflects very strong population growth in New Zealand until the beginning of the pandemic. Since the global financial crisis (GFC), New Zealand has experienced almost the highest rate of population growth across the OECD, in large part off the back of a migration boom. Since we have failed to build enough houses for a growing population, it is not altogether surprising that we have had the largest increase in house prices. This reflects one of the underlying issues that New Zealand faces: our supply of new houses has not kept up with the demand for housing coming from a growing population. However, this is by no means all of the story.

Interest rates are another key driver of housing demand. For example, lower mortgage rates mean people can borrow more for a given level of income, making it easier to fund a house purchase. This stimulates a higher demand for better-quality properties, pushing up prices if more supply does not come on stream.

Interest rates fell steadily after the GFC, both in New Zealand and around the world. For example, while a new bank customer in New Zealand could lock in a two-year mortgage at almost 9 per cent in 2008, they could get the same mortgage for just under 4 per cent in 2021.

A wide range of factors influence interest rates. Monetary policy has short-term, temporary impacts on interest rates over the course of the business cycle. Central banks control inflation by moving policy interest rates either side of the so-called neutral interest rate to "lean against" the business cycle – that is, to slow things down in a boom and to stimulate activity in a slump.

The neutral rate is the interest rate at which inflation is low and stable and employment is at its maximum sustainable level. The long-term decline in the cost of borrowing reflects a drop in the neutral interest rate over the course of decades rather than over the business cycle.

Best estimates of the neutral rate show it has fallen across OECD economies over many decades, and the GFC triggered an even sharper dip. Here in Aotearoa, Reserve Bank estimates of New Zealand's neutral rate shows a three-percentage-point drop since the mid-2000s.

There are a host of possible reasons why neutral interest rates have fallen in recent decades. For example, with people living longer, savings have increased to pay for longer retirements. Also, the hardships that followed the GFC caused people in many countries to spend less, building up precautionary savings to insure against income uncertainty.

With relatively weak productivity growth since the GFC, the returns on investment and demand for investment funding have been low. Overall, these and other forces buoyed global savings rates, creating vast pools of capital that have flowed through liberalised international financial markets to finance investment needs.

In short, a worldwide savings glut is likely to have lowered neutral interest rates. As global neutral rates declined, borrowing costs dipped to historic lows, and house prices increased in many countries. In New Zealand, as in many other countries, falls in the global neutral interest rate played a dominant role in the long-term increase in house prices, dwarfing the effects of changes in shorter-term interest rates and rents.

This is not to say that temporary cyclical interest rate changes driven by Reserve Bank monetary policy are not important. The New Zealand experience is that a temporary easing of monetary policy, for example, leads to a temporary increase in house prices. However, the more persistent upward trend in our house prices is mainly driven by the persistent decline in the neutral interest rate, which has, in turn, been affected by global forces.

Our tax system may have also contributed to higher house prices in recent decades. Capital gains on housing are often not taxed, whereas other forms of income are.

Imputed rent (the rent owner-occupiers effectively pay themselves) is not taxed, whereas other forms of investment income are. And GST is charged as a lump sum when a house is built, rather than on the flow of housing services as they are consumed, be that via rent or owner occupation.

These tax distortions that favour housing become more potent when interest rates are low, amplifying the effects on house prices. So, as interest rates fell between 2002 and 2021, it is likely that the upward impact of tax settings on house prices increased.

If the tax system had been more "neutral" in its treatment of housing, house price increases would have been milder over the two decades to 2021 as interest rates fell.

Of course, a fully non-distortionary neutral tax system is merely an economist's fantasy; indeed, there are practical considerations that influence the design and implementation of tax systems. Nonetheless, understanding the impacts of tax distortions – and their interactions with other relevant factors such as interest rates – on the housing market is important for understanding house price dynamics.

Higher housing demand will have a much smaller impact on house prices if new homes are built quickly to meet that demand. For example, our analysis shows that house prices are less sensitive to temporary changes in interest rates in areas of the country where new homes are built relatively more quickly to meet demand.

A recent report by the New Zealand Infrastructure Commission finds that the response of house prices to population growth between the late 1970s and the late 2010s was about four times lower than it was from the late 1930s to the late 1970s. It would seem that, consistent with rapid house price inflation, the supply of housing over recent years has been slower to respond to increased demand.

There are two key components to housing supply: the house itself and the land on which it is built. Land markets in New Zealand are critical in explaining high house prices. If the space for new housing – both up and out – is restricted or difficult to access, increased housing demand gets captured as changes in the price of land, rather than as more houses. On the other hand, when there is space available for new housing, increased demand will see more houses being provided with more modest impacts on prices.

Modelling by the Infrastructure Commission in 2022 shows that changes to urban planning policies that constrained land supply explain much of the acceleration in house prices in recent decades. Similar results on the effect of land-use regulation are echoed in studies of a number of cities in New Zealand.

Previous work for the Ministry of Business, Innovation and Employment and the Ministry for the Environment showed that land within the urban boundary can be $200-$300 per sq m more expensive than surrounding rural land. The steep difference in prices across the urban boundary shows that land-use regulation has an important impact.

World Bank data shows that construction costs in New Zealand were 16 per cent higher than in Australia and about double the OECD average in 2017. In 2012, the New Zealand Productivity Commission's Housing Affordability Inquiry also showed building costs were high here relative to other countries. Despite being high already, construction costs have increased faster in New Zealand than in other countries since the GFC. This all strongly suggests that house building in New Zealand is an expensive business.

There are no doubt many reasons why building costs are so high here. Part of the reason could be that the manufacture and distribution of building materials – which account for almost half of construction costs – take place in industries that are dominated by one or a small number of large firms. In addition to weak competition, some building supply businesses are likely to be relatively unproductive and to produce below minimum efficient scale.

What do these and other fundamental drivers of the housing market mean for house prices? To help answer this question, Reserve Bank researchers have estimated the level of "sustainable" house prices consistent with market fundamentals, such as the cost of alternatives to owning a property, the longer-term outlook for interest rates and expected future supply-and-demand conditions.

Not surprisingly, given weaknesses in our ability to provide enough space for new housing for a rapidly expanding population, the tax system, and the decline in neutral interest rates internationally, "sustainable" house prices have increased strongly in New Zealand over recent years. [The bank defines sustainable house prices as the level that house prices should move towards based on factors such as incomes, population growth, housing supply, tax settings and interest rates.] This increase reflects the fact that market fundamentals have been key in pushing up actual house prices over the past few decades.

Actual house prices can and do deviate from "sustainable" house prices as a result of short-run influences, such as monetary policy and the "animal spirits" of market participants. Monetary policy influences how house prices evolve around the sustainable level but is unable to keep house prices persistently above or below their sustainable level.

Since the beginning of the pandemic in 2020, actual house prices have been above their sustainable level. Exceptionally low interest rates coupled with a "fear of missing out" would have contributed to this cyclical surge in house prices. In turn, stronger house prices supported consumer spending over this period through a wealth effect. This additional support to aggregate demand and spending in our economy played a key role in helping us avoid the worst effects of the pandemic on employment and income.

Importantly, "sustainability" and "affordability" are very different concepts. While sustainability is determined by fundamental drivers in the housing market, affordability is about where the cost of purchasing a house sits relative to the income of the homebuyer. Unfortunately for many New Zealanders trying to buy a home, the current level of sustainable house prices – determined by market fundamentals – is still by no means affordable.

With strong demand and constrained supply, rapid house-price growth over the past 20 years or more has meant that residential property, as an investment asset, has delivered strong financial returns for buyers. With prices having been seemingly always on the up, it is no surprise that New Zealanders hold a relatively large share of their wealth in housing.

The proportion of housing wealth in total wealth appears to be relatively high in New Zealand compared to other developed economies. Given large house price increases, research based on portfolio investment theory shows that investing in residential property has been the logical choice for many Kiwis.

In New Zealand, given policy settings, it has been rational for investors to flock into the housing market. Because housing can be leveraged, the flip side of strong investment in residential property is that mortgage lending makes up a larger proportion of commercial bank balance sheets compared with other OECD economies.

Although investing in housing has been rational, the implications of channelling a very large share of our savings and debt obligations into housing goes beyond optimal portfolio theory. The housing market has become the default savings vehicle for many New Zealanders, and the key source of collateral or security for borrowing by households and small and medium businesses.

It may also be that investing in housing in the hope of perpetually higher house prices may ultimately lead to a potential misallocation of resources that generates relatively little economic value.

Over the years, the demand side of the New Zealand housing market was boosted by strong population growth, steadily declining neutral interest rates and a favourable tax system. The supply side, however, has been held back by strict land-use regulations and a construction sector prone to boom-bust cycles while carrying very high building costs. Excess demand led to New Zealand's experience with some of the highest house prices relative to income in the world.

A sense of ever-increasing house prices – along with a lack of other quality local investment alternatives – may have also distorted the investment options of New Zealanders. The share of housing on household balance sheets is very high and commercial banks hold a high share of mortgages on their balance sheets.

Rapidly increasing land prices may have also led to a transfer of wealth from landless younger people and future generations, who have to spend more to buy land, to people who owned land as prices were rising. This means that landless younger people and future generations save less, reducing the amount of alternative capital they own and possibly lowering lifetime consumption and incomes.

Are these dynamics likely to continue in future? Since August 2021, the Reserve Bank has been tightening monetary policy, lifting the Official Cash Rate, to rein in inflation. This will likely see actual house prices move back towards "sustainable" levels that are more in line with market fundamentals. Indeed, in the May Monetary Policy Statement, we forecast a 15 per cent decline in house prices from their peak, which would bring them roughly back to sustainable levels.

Over a longer time frame, there are reasons to think that some of the core market fundamentals that determine sustainable house prices may also be changing.

On the demand side, as the pandemic slowly recedes and international travel restrictions unwind, many New Zealanders are heading overseas seeking new experiences. On the other hand, immigration is unlikely to return quickly to pre-pandemic levels, contributing to slower population growth overall.

In the tax space, the removal of interest deductibility and the introduction of a capital gains tax on sales of residential [investment] property owned for less than 10 years – the "bright-line test" – will have closed some of the gap between the effective tax rate on housing and other asset classes.

At the same time, urban planning rules are being freed up to unlock more housing supply. The Resource Management Act is being replaced and the National Policy Statement on Urban Development directs councils to remove overly restrictive planning rules and to enable higher housing density, which is a critical part of the solution.

In the construction sector, the Commerce Commission is carrying out a market study into whether competition for residential building supplies in New Zealand is working well and, if not, what can be done to improve it.

These changes are consistent with more houses being built and currently high building consents translating into more actual houses. They also imply that housing market dynamics in future are unlikely to be the same as in the past. Given the importance of housing in our economy and national psyche, this will be a huge change.

For several decades, we have traded houses among ourselves at ever-increasing prices in the belief that we were creating prosperity. But the tide may well have turned against housing being a one-way bet for a generation of Kiwis. We need to keep building a new approach to housing and economic prosperity in Aotearoa-New Zealand.

This is a speech Paul Conway gave to the National Property Conference on June 30.